Part of the Insurance Asset Management, North America 2016 report
Round table chaired by David Grana, Head of North American Media, Clear Path Analysis
Panellists:
- Elizabeth Jourdan, Deputy Chief Investment Officer, Mercy
- Rip Reeves, Chief Investment Officer & Treasurer, AEGIS Insurance Services
- Mark Silverstein, Chief Investment Officer, Endurance
David Grana: How far down the credit rating scale do you need to go – or will you go – for decent yield?
Mark Silverstein: We haven’t structurally shifted our portfolio to be necessarily lower in quality. Our focus is managing the portfolio at the desired risk level. We do have BBBs. And outside of high grade fixed income, we have allocated to High Yield (HY), Bank Loans (HYBLs) and emerging market debt.
Rip Reeves: Similarly, we haven’t re-positioned our portfolio down in credit quality for yield pick-up and potential return. Having said that, we have gradually increased our allocations to lower credit quality issues over the past few years. Within our below investment grade mandates, we have a BBB/B- minimum credit quality, with opportunistic use of credits rated CCC (10% maximum).
We also have a short duration target on our below investment grade mandates, and we utilize a flexible multi-strategy approach in the sector. We allow our managers to invest across the capital structure, to include traditional HY bonds, HYBLs, collateralized loan obligations (CLOs), convertible bonds and other structured products.
Elizabeth Jourdan: A lot of our fixed income asset managers have been really pushing the relative value of BBBs. Historically, they have tended to do so anyway, but particularly over the past 9 months. We’ve kept the portfolio fairly up-in-quality to maintain liquidity – we’d rather take risk in other asset classes.
David: Are you looking at asset classes that you would invest in outside of bonds to attain some of the yield that you wouldn’t be able to get in the fixed income space?
Elizabeth: We have increased our allocation to private investments and have a dedicated allocation to private credit. Earlier in the year, we invested in CLOs, European non-performing loans and high yield dislocation funds. I have also been hearing from many insurance peers of their interest in direct lending and commercial real estate debt for the yield, although that hasn’t been a place we’ve allocated.
Rip: Over the past few years, we have done the “liquidity trade”. We used some of our excess liquidity and gone into direct lending, real estate equity and utilized the Held-to-Maturity accounting classification. Investment allocations into less liquid alternatives have been gaining momentum in the insurance sector, and we have been investing in these areas for the past five years. Investments into liquidity constrained mandates necessitates a rigorous monitoring process on our excess liquidity levels to ensure proper cash for the Enterprise.
Mark: We haven’t taken the middle market direct lending route. Our non-investment grade credit exposure is primarily HY, HYBLs and credit hedge funds. We have considered giving up liquidity to participate in private placements for investment grade credits and commercial real estate mortgages to enhance return and further diversify. But we haven’t taken any action to date as we determine where we are most comfortable in giving up that liquidity. The unusual thing about an insurance company is that we have plenty of liquidity, but are reluctant to give it up through certain kinds of investments. We have to make sure that we are getting a good bang for our buck, because with illiquid strategies, we aren’t going to be able to change our mind for a long time.
David: Mezzanine credit wouldn’t then be on your radar?
Mark: No, for the most part, we have used our illiquid bucket for hedge funds - in the distressed area and structured products. We have done a few things on the liquid side in an effort to add more diversity to our credit exposure in areas where we see value. We are invested in emerging market debt, and we have also done some investing in the junior CLO traunches which we compare to HY or HYBLs depending on the credit quality. We also have AAA-rated CLO traunches in the high grade portfolio, which are pretty cheap relative to other investment grade credits. They have performed fairly well because there haven’t been defaults of any sort to date. Granted, you do get periods of poor liquidity, which costs you in total return performance at times. But over the long run, we have done fairly well with that approach.
David: Since everyone else is seeking yield, do you see a crowded trade, whereby yields of non-investment grade assets are being pushed down to levels that are making even those investments unattractive?
Rip: The yield trade down in credit quality is a trade many insurance companies have been implementing since the 2008 Financial Crisis. Therefore, many of us have pushed that trade as much as we feel is suitable. I wouldn’t say below investment grade sectors are unattractive, but they’re never as attractive as we’d like them to be when funding! In an investment environment, where asset classes are not statiscally cheap,we generally reduce other forms of risk embedded in the credit quality decision. For example, we reduced the duration of our below investment grade portfolio by half -- to 2 years. Another example is to diversify a larger number of active positions in the mandate, given a more fully valued asset class.
Elizabeth: For below investment grade corporate credit, not really unattractive but rather just fair value. One place that hasn’t felt crowded is parts of the legacy CMBS market, which hasn’t participated in the high-yield rally we’ve seen so far this year. There is also a life and health insurance company here in St. Louis which, in looking for yield, started originating commercial mortgage loans directly and it’s developed into a pretty large program.
Mark: There is a lot of pressure on people who are looking for yield, especially with rates so low all around the world. While some areas are crowded, I am not as concerned about whether a crowd is driving up prices as much as making sure that we are getting a fair spread for the risks that we are taking. If that crowd causes prices to be unfair, we are less interested. The areas that seem to check the right boxes for most investors tend to be priced too high. For other items that don’t check the right boxes, there tends to be better value. CLOs tend to trade at favorable prices because too many people put them in the box of being too complicated. They have periods of illiquidity and aren’t likely to be a crowded area. Whereas, at times, BBB credits could become a crowded area because they are investment grade and will fit into many investors’ guidelines.
Given the level of rates, there is less risk of demand vaporizing. The market can have air pockets for a week or month, where things can look scary. But fundamentally, there is good demand out there for yield. While we value income, we are much more total return oriented. Having a fair amount of our return generated through income is beneficial because it is consistent. But we won’t do something because it has income in it. That is just one of the trade-offs to consider in an investment decision.
David: The National Association of Insurance Commissioners (NAIC) is now examining the capital charges based on the risk of investments which is then going to impact the rating agency scrutiny of how they rate you as insurers. What are some of the limits that you have as a result of what the NAIC and the rating agency decide on how much you can allocate into non investment grade?
Mark: The rating agencies tend to have capital charges bifurcated. For investment grade credits, the risk charges are generally low, but for HY, they are quite high, so it does have some impact. Fortunately, we are in a position where we have plenty of capital to cover those capital charges. To date, our allocations have been driven by our view on economic risk and expected return, while being aware of the capital charges, but the charges aren’t constraining factors in our decisions.
Rip: In our asset allocation process, expected total return, income and risk budgeting for the enterprise are paramount. The rating agency consideration is absolutely part of our asset allocation process. However, it generally is not a primary driver. We have not found rating agency issues prohibitive to date, given we approach our rating agency relationship with complete transparency regarding our asset allocation analysis and the risks we are potentially taking with new mandates.
Elizabeth: The recent flight out of hedge funds by insurance companies, such as with Metlife and AIG, has been interesting. Of course they weren’t hitting their return hurdles, but then on top of that, getting hit with higher capital charges. So in allocating to risk assets, it’s a factor for many US insurers that need to make sure they arehitting the return hurdles to justify the capital charge.
David: Is 5-10% of the portfolio allocated in non-IG a fair number that you would have your portfolios allocated to?
Elizabeth: That is a fair number. The insurance company I worked for previously has had an allocation between 20-30% in alternative assets in the past (including non-investment grade fixed-income), but this is a max, from what I have seen.
Rip: We are slightly above 10%, but our below investment grade mandate is not just traditional HY bonds. Embedded in our HY mandate are several sectors where many P&C insurers invest in a “silo” approach. We have a multi-strategy approach to the below investment grade space to include HY, HYBLs, CLOs, convertible bonds and other structured product. Additionally, we have a 2-year target duration and a BBB/B- minimum credit quality.
Mark: Our HY orientated investments total around 13% of the portfolio, but it is allocated to a variety of sub-sectors. Our allocation includes generic HY and HYBLs, but we also have credit distressed hedge funds, emerging market debt and distressed real estate private equity. We count the latter as HY, because they are working out distressed debt through re-structurings. In summary, while credit has a meaningful allocation, it isn’t just HY, which is why we call it HY orientated investments.
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